Credit creation is the multiple expansions of banks demand deposits. It is an open secret now that banks advance a major portion of their deposits to the borrowers and keep smaller part of deposits for payment to the customers on demand.
Even then the customers of the banks have full confidence that the deposits lying in the banks are quiet safe and can be withdrawn on demand. The banks exploit the trust of their clients and expand loans by much more time than the amount of demand deposits possessed by them. So, the tendency on the part of the commercial banks to expand their demand deposits as a multiple of their excess cash reserve is called credit creation.
Ways of Credit Creation:
The single bank cannot create the credit. It is the banking system as a whole, which can expand loans many times of its excess cash reserves. Commercial bank can create credit in following three ways:
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Discounting of Bills:
A bank also create credit through discounting of bills of exchange. In this method, the bank discounts the bill and issues a chequebook after the opening of account for the amount of discounted bill instead of giving cash.
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Supply of Loans:
When a bank agrees to grant loan to a borrower against the securities than it opens an account of the borrower for the granted amount of loan instead of giving cash. If the borrower wants to make payment to another person than it issues the cheque, which is deposited by the receiver into another bank. In this ways the process of credit creation goes on.
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By making Investment:
A bank also creates credit by making investment in securities. It buys securities from stock exchange and then credits the amount in the account of the seller or it pays a crossed cheque to the seller, which he can collect by depositing it into his bank account.
Limitations of Credit Creation:
The power of commercial banks to create credit is not unlimited but there are many limitations on the power of banks for the creation of credit, as follow:
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Cash Reserve:
A bank cannot lend all of its funds. It has to keep a reasonable portion of its funds meet the demand of its customers(depositors). If more funds are required to meet the demand of depositors, then the power of credit creation will be lower.
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Central Bank Policy:
The commercial banks are not independent in connection with leading. The central bank of the country can impose certain restrictions on banks to create credit or to expand loans by credit control measures.
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Willingness to borrow:
If the people are not willing to borrow then credit cannot be created. It means the bank has to find customers in order to extend credit.
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Habit of Customers:
If the borrowers get the loan in cash and make the payments in cash instead of cheques then the banks cannot create the credit. So the use of cheques is necessary for multiple credit expansion.
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Shortage of securities:
Banks demand the securities from the borrowers at the time of granting loans. If the borrower is not in the position to fulfill this requirement than the bank will not grant the loan.
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Primary Deposits:
Banks can create credit only if they get primary(new) deposits that is why it is said that “deposits create credit and credit creates deposits”.
Read More:-Cash Flow Management